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Every industry has its own "Grind Down". Perhaps it goes by another name, but our firm refers to a "Grind Down" as a negotiating tactic that occurs in deals when one party or the other at the last minute tries to achieve more favorable terms for itself or threaten to back out of the deal at a time so late in the game that the other party cannot find another transactor.

Most homeowners have experienced the common retail mortgage grind down where when you go to buy a house and the deal is about to happen that the lender has some funny stuff fees in the transaction that you must pay. It is too late to find another lender and failure to go through with the deal opens up the property to another buyer. The other common grind down is from one party who asks for excessive concessions after the inspection and then threatens to back out of the deal if those concessions are not met.

In any deal, particularly private equity negotiations, there are lots of Grind Downs. One way some firms put the press on their portfolio companies is by not letting other co-investors in the deal. In the initial investment the firm promises to feed the startup until a liquidity event. These assurances allow that investor to be the sole investor and prevents the need for the company to deal with multiple investors. However, inevitably the company burns through that round of cash and needs another round of funding. The investor presents a term sheet and drags on signing it until the company is nearly out of cash. Suddenly, they must change the terms of the term sheet and so the company must sign the deal with those terms otherwise become insolvent.

As in any transaction it is imperative to create a market for your investment so that you can get a competitive price.

Not that I really care or that I even keep track, but today someone informed me that TechCrunch has posted the top 100 VC blogs based on number of Google Reader subscribers. This blog came in at #53 and I thank all the readers who continue to enjoy its content.

When this blog started it was more of an experiment to help me flush out my thoughts and post on interesting topics specifically in the field of venture capital. Over time, I really couldn't help myself but post on all areas of private equity that I am involved in including real estate, hedge funds, leveraged buyouts, and general market commentary. Hopefully I haven't alienated too many readers by broadening my horizon.

While Google Reader is only one source of readers of this blog and this list doesn't really mean much, it does confirm that there is a hunger out in cyberspace for information on the overall venture and private equity industries. And we all know that where there is demand, supply will come.

I am happy to be one of those suppliers of information. Feel free to drop me a line anytime with questions, ideas, or comments. Thanks again for joining me in this rewarding endeavor.

It's been a while since I posted but a reader recently asked me to comment on Hurdle rates. For those of you not familiar with what a hurdle rate is, it is generally the preferred rate of return an investor requires to make an investment. Some refer to it as "cost of capital". If you consider the many options of where money can go to make a return, for an investment to be attractive it should exceed the most commonly available rates of return. There are many differing opinions on what this common rate of return should be. For example, some people feel that a good preferred return is that of what money would cost to borrow from a bank such as 7% on a fixed 30 year loan or a few points above LIBOR. Others may use a benchmark of the average return of a broad stock index such as the S&P 500.

Another way to look at the hurdle is the percentage return after which a fund manager can charge fees. For example a manager may say that his fees will only be charged on the return in excess of the hurdle. The logic is essentially that the investment should return better than a commonly available return and thus only fees should be paid on that excessive return.

I have never been a fan of hurdles or preferred returns in private equity. The main reason is that I am not a nickel and dimer and if I am investing in an investment looking for an outsized gain I am not going to fuss over the terms of a preferred return. If I wanted a hurdle type of return I would just put my money in a mutual fund or buy a piece of commercial real estate and get a good cap rate. When I invest, I want the manager to make big returns and be rewarded on the back end for the great return.

It is sort of analogous to investing in public equity for dividends. I am not a dividend investor and would never invest in a stock for its dividends but more for its appreciation. Additionally, in a private venture type investment, taking a dividend in a startup does not make sense to me because you want the cash to stay in the company to add value to the equity. An LBO is a different scenario because the company is cash flow rich and taking a dividend should not weaken the company materially.

Thus to me the hurdle rate should be a non-issue and in a private deal where I am looking for a good return, I do not want the manager to focus on the hurdle. I would rather that it be clean and simple. I want to be able to calculate the return and fees that I paid to the manager in my head or on the back of a napkin, not through a complicated spreadsheet.

If I am investing in a fund, I am looking to build a relationship is someone who can earn good returns over any cycle. I may negotiate some terms or fees, but the hurdle certainly is not one of them. I would rather go with a talented manager with a low hurdle than a first-timer with a high preferred return.

I've received lots of comments on my previous post about creating a Due Diligence Binder. As I mentioned previously, you want to provide your investor adequate information for them to research you and your company. The more you provide, the better they can evaluate you. While some entrepreneurs may be leery at providing this kind of proprietary information to outsiders, you must understand that your investors will be spending money to investigate you - take this as a sign that they are serious about your company. If you desire, you can make them sign non-disclosure. If you are paranoid, you might go as far as setting up a clean and confidential room such as may be used in an M & A process. One easy alternative is to create a truncated DD binder and leave out key pieces that may be requested as appendices.

So here is what I like to see in a solid DD binder:

1. Background of company since inception2. Background of key personnel3. Business plan and all previous versions, including exit strategy4. All correspondence to previous investors5. All audited and unaudited financials since inception6. Discussion of performance7. Capitalization Table8. Lease agreements9. Employment agreements10. Purchase or sale agreements11. Previous letters of intent

As I mentioned in my last post, if you are just starting up, you want to have reporting processes in place that make it easy to update this DD binder on a quarterly basis. You want to be able to get this out to people immediately if they request it. If you are an established startup and are now just putting together a DD binder, your investor will probably be able to see that you are not that organized and that you really haven't done this before. This may or may not pose a problem, but if your financials and accounting are crisp and clean and you have a nice reporting system in place already then your investor will surely know that accountability and reporting are not going to be an issue.

In this day and age of electronic networks, there are various on-line reporting systems that are used by private companies or investment companies to deliver correspondence. Many open-minded institutions post all of this information that might be included in a DD binder on this network and make it available to potential investors. I will admit that this is somewhat rare, but I have done due diligence before on a firm that gave us access to their intranet that contained all correspondence and reports for all of their previous and current funds. Suffice it to say that we found no holes in any of their documents and reporting and they have one of the cleanest books that would make any LP sleep comfortable at night.

As you can imagine, this is a generic list of items that will need to be tailored according to industry or type of company. For example if your startup is an investment company or private equity firm, you will want to focus more on track record and perhaps investment strategy. You may want to include a list of previous investors or key LP relationships or even letters of "soft" commitments from LPs to shows that you will not have problems raising investment funds. Because investment firms tend to rely on key personnel, one thing I do like to see is a discussion of exit strategy of the key principals including how long they plan on being with the company and what their personal investment in the firm has been to date.

I wanted to take a moment to congratulate Andy Klein and his team at Spotzer. Spotzer recently announced a Euro 10 million investment from Sierra Ventures and European Directories. I must disclose that we invested in the angel round at Spotzer.

Spotzer is an exciting company working in the white hot space of highly targeted and affordable advertising. Spotzer is based in Amsterdam with offices in the UK, San Francisco, and New York. They hope to become the first truly global advertising company in the highly targeted video space.

In thinking about Spotzer's new investment, it reminds me of the importance of taking on investors strategically for reasons besides money. Often it is not the best "deal" that you should chase, but the most doors a potential investor can open.

Spotzer's list of strategic investors:

Dutchview BV - Holland's largest post production company serving the Dutch population.Cyrte Investments - media investment firm with deep relationships in the NetherlandsEuropean Directories - pan-European directories service group with strong marketing holds in most of EuropeSierra Ventures - California based firm with a strong record in the United States

In any area, it is important to get strategic investors. In the space of global media advertising, it is essential. Without those investors to open doors to get into media networks and get national creative agencies to sign on to your product, you face a huge uphill battle.

Let's briefly take a look at Spotzer's largest competitor, Spotrunner, based in the US. Spotrunner's investors:

As you can see, strategic investment is the key to thriving in any sector, particularly advertising media.

I expect this space to flourish over the next few years with a few possible public offerings on US or global markets. As more and more of these types of companies continue to receive funding, there will also be a nice wave of acquisition and consolidation.

I was sent a link a few days ago from Inside CRM. They have their list of 20 Worst VC investments. I've taken a look at them and do remember vividly when most of these companies were funded. It's easy to look back in hindsight and say that a venture investment is bad. From the outside, all you see is the amount of money put into an investment. Some time later you hear that they are bankrupt.

I'll be the first to admit that there are a lot of VCs out there that have thrown lots of good money after bad ideas. But venture capital as an industry involves both "good" and "bad" investments. One could argue that all of the excesses of a frothy investment cycle are necessary for progress. Would Google or YouTube have been funded without this history of excess? If every venture investment was a winner, everyone would be a VC and undoubtedly, the value of successful companies as a whole would probably be less.

It's clear to me that "bad" investments are a necessary evil in the venture industry. Sometimes the only way to see if an idea will work is to fund it and give it your best shot. If you take a closer look at many of these companies, there are similar concepts that exist today on the internet that either made it through the crash or were revived through a new startup. This tells me that either the original strategy implementation was incorrect, the management could not execute, or it was the wrong time for the concept.

There have been a handful of news articles recently talking about how the advertising market cannot support all the startups going after that space. This brings me to something that I've always felt about startups and advertising - Adversiting Can't Be Your Only Business Model.

I know this is somewhat controversial among venture capitalists. Some VCs believe that advertising is a great business model. Others don't. If you look at a company like Google, you'll find a company who is in the business of delivering ads as a middleman. This is not the business model that I am referring to. Google's business will wax and wane as advertising dollars do, but it will always be in the business of connecting advertisers with portals for advertising.

In contrast to Google, you've got thousands of startups whose business model is based on advertising, page clicks, page impressions, etc. These are the companies who in my opinion have dubious business models.

There is only one reason that advertisers pay money to advertise - BECAUSE IT DRIVES COMMERCE. If it did not increase commerce, then that company would not pay for its advertising. In the business world, page views and eyeballs are only important if they can be translated into dollars.

Thus, I advise all companies that I am involved with that your business model should do something to drive commerce. If it doesn't, then it really is not going to be that valuable. If you can get X million page views, it is only worth something to another company because it could translate into big dollars. Why not figure out a way to get those dollars directly?

For those of you who are starting that next web startup, try incorporating some direct commerce to earn some steady revenue that is independent of the advertising market.

I continue to receive a lot of inquiries from people who want to run money or put together deals. Typically what I see comes in three flavors:

1) an entrepreneur looking for capital2) a fund looking for LPs3) a developer looking for equity or debt for a real estate development

I welcome these inquiries, but for those who are sending information here are some thoughts that might help you understand our process. All of our deals go through an investment committee. Occasionally I will invest personal funds into deals that the committee rejects. However, typically, we either file the PPM or decide that it is a promising manager but that either we do not know them well enough or it does not fit any of our stage, geographic, or stylistic allocations. For those managers that we like and we do not commit to, we encourage them to keep us in the loop and begin a discovery type of relationship. We encourage them to send us correspondence regularly and treat us as if we were an LP in their fund. I can say that 99% of the time this does not happen. However, the 1% of the time it does happen, it allows us to really understand the ethos and style of a firm. We have found that firms that are willing to take this effort and have this type of "open door" policy are the types of managers we want to partner with. We will wait in line to invest and partner with these types of firms, assuming that their performance is good.

For entrepreneurs or developers looking for capital, we are happy to give you feedback and/or direct you to partners or colleagues within our network who may have an interest.

Now that I've cleared that up, here is the main point of this post:

Whether you are looking for capital for your startup, for your fund, or for your RE deal, the bottom line is that you are "Running Money". I use this term loosely because "Running Money" typically refers to the money management business. I happen to believe that when you take someone's funds with the promise of some sort of return, you are Running Money.

The most important thing about Running Money is to understand that Running Money is really about building relationships. I know that sounds pretty cliche, but the best managers or entrepreneurs are those who understand this concept. They are not so focused on bagging the big fish one time. They understand that in finance, your last fund or deal or company is not all that matters. It really is about your track record of performance and your track record of how you treat people. If you treat each investor or partner as a lifelong business partner, you'll soon realize that people on the other end are not necessarily just about returns. They do have an interest in being a part of something successful and larger. They do have an interest in building something rather than just riding coattails. But you have to consciously make efforts to do this through your words and actions. We continue to back managers and entrepreneurs who have had an unsuccessful fund, company, or deal if they have acted responsibly and continue to have promise. Similarly, we expect our partners to continue to back us if we have an average fund.

It's quite easy for me to distinguish when someone just wants money versus someone who wants money, advice, or a partner for their business journey. I continue to enjoy working with and investing with younger managers or entrepreneurs or established managers who are lifting out on their own for this precise reason. If you take the long view you will not just focus on this one fund, or one RE deal, or one company but rather perhaps on your firm, your career, and your network of relationships.

I haven't written in this series in a long time, but one of my readers recently asked me to comment on the differences between exit strategies of VCs and Private Equity buyouts. Let me first say that VC firms and LBO shops differ in their strategy and culture.

Some venture firms are old school and want to create long term value while transforming the way the world works. Some venture firms are just about the exit and the ROI and really don't give a hoot about the business other than providing a nice return so they can go out and raise a bigger fund. Similarly, in the buyout world, you have old school corporate raiders in the style of Gordon Gekko that love to carve up companies for the value. You'll also find a lot of very conservative buyout guys that like to build businesses and create value for shareholders. Typically, they will provide a nice piece of equity infusion for the company to then acquire complementary businesses or fund new projects. As you can imagine, the lines may blur between conservative LBO investors and aggressive venture investors. Those venture investors that use debt offerings sure do look an awful lot like conservative growth equity LBO players.

In my opinion, the important difference between the VC and buyout in terms of exit strategy and liquidity is that while both of them have a clock ticking, there is a different expectation, urgency, and ultimate multiple goal between the two. A venture firm must provide returns to its investors and has a long horizon to do so. Therefore, it has to make a high multiple on its investment and must hold out for a nice acquisition or an IPO. So it must build the business from scratch to be able to carrry a very high enterprise value.

On the other hand, a buyout firm, while it does have investors to report to, uses leverage for its transaction so it must pay off its lenders and service debt. Thus buyouts are bank driven deals. A bank won't lend a venture fund money to invest in a startup because it knows that it will probably go down in flames. A bank will lend a buyout fund money because there is collateral in place, and that collateral comes in the form of a company's cash flow and assets. So a buyout fund will seek companies that are undervalued with high predictable cash flow and operating inefficiencies. If it can improve the business, it can sell the company or its parts, or it can pay itself a nice dividend or pay down some company debt to deleverage.

The essential difference is that the venture funded company has little to no debt because it has issued equity. The buyout funded company has issued equity and loaded on debt.

As for the actual exit, a venture fund will usually go for the IPO or acquisition. The highest valuation will usually be what is available on the open market and that is why a venture fund will try that route first. A buyout fund will go for either of those but it also has the option of paying itself out some cash or of selling off parts or of selling in a secondary buyout to another firm.

I hope that answers some questions and feel free to ping me any questions.

If you haven't heard already, Google has purchased Feedburner. Fred Wilson gives some color to the deal on his blog. While terms were not disclosed, Fred admits that his firm made about 3 times its money on the deal. That doesn't sound like a "homerun" but he clearly outlines how rewarding the investment was for him and his firm in terms of personal satisfaction and in learning about the new media feed world.

This transaction confirms what few prescient VCs have known is the next wave of startups that take advantage of new media. Several years ago no one knew what a widget was or what a feed was. We were all using email and looking at portals and webpages. A very small iteration occurred, and that included the "blog", the "feed", and the "community". In the past few years these have taken off and it remains an undercapitalized investment category simply because a lot of VCs don't understand the power of this space.

Now some would argue that these aren't new concepts after all. The original webpage is basically a blog. A feed is basically a piece of directed spam. And a community is simply the readers of a portal.

So what exactly has changed? In my mind, the main thing that has changed is that savvy entrepreneurs have figured out a way to provide "turnkey" solutions for the masses. Now you could very well argue that software had already been created to provide this turnkey solution. However, those solutions never took off in the past like they have today. I believe the reason is because these solutions now come in SaaS "Software as a Service" models - no software on the computer - everything online.

I'm still bullish on these new media companies run by very smart people that are very low cost to build and scale. These companies use viral marketing to spread like wildfire. And they get gobbled up by giants soon after their popularity grows.

The best thing about them is that they essentially become successful in the same way that most companies get successful - they package a turnkey product and make it available for the masses.